Zynga Enlarges Its War Chest

Russian investment group Digital Sky Technologies grabbed the spotlight of the D: All Things Digital conference in May with the announcement that it was investing $200 million in Facebook. But behind the scenes of the San Diego summit, DST was laying the groundwork for its next big U.S. play. Through a mutual friend, DST partner Alexander Tamas held a meeting with Mark Pincus, whose gaming startup Zynga would soon become the talk of Silicon Valley. The encounter paid off. On Dec. 15, Zynga said it would take $180 million in funding from DST and other investors, including the fund maintained by Web pioneer Marc Andreessen. Analysts say that's a lot of funding for a profitable company that has barely touched the $39 million in venture money it raised in 2008. With its new millions, Zynga plans to spend heavily on technology equipment and, potentially, acquisitions to outmuscle new challengers in the rapidly growing online gaming world. In particular, the company has its sights set on Electronic Arts (ERTS), the video game publisher that in November made a big push into online gaming with its $300 million acquisition of Playfish. "This opportunity is going to be bigger than any of us estimate, and I want to have a big enough chip stack so we can keep scaling," Zynga CEO Pincus says in an interview. At the same time, the injection of funds keeps at bay for now what many view as inevitable for Zynga: an initial public offering. Millions of GamersThe maker of popular free games like FarmVille and Mafia Wars, played between friends on Facebook and by users of Apple's (AAPL) iPhone, Zynga is swiftly building a huge community of gamers. Currently, more than 230 million people play at least one Zynga game a month. Many spend real money on so-called virtual goods, such as decor and kitchen appliances for restaurants in make-believe Café World. Supporting tens of millions of online gamers each day is costly. Unlike games that are downloaded to a computer, such as World of Warcraft, Zynga's applications are run almost entirely on Web servers that are maintained by Zynga. "It's not infrequent that [Zynga games] experience glitches of one sort or another," says Lewis Ward, analyst at research firm IDC. That's probably why the company is looking to ramp up spending on expensive data centers that keep the games running smoothly around the clock. Technology to support security and network operations centers, which help manage and monitor Web traffic, are also on the shopping list, says Pincus. "I have to write a lot of big checks for things that don't sound sexy," he adds. Pincus may also tap the war chest for a big acquisition. Though Zynga has until now purchased only small gaming companies, mostly for the talent, it may strike a larger deal to avoid being left behind by a competitor. The Playfish deal, announced Nov. 10, gave one of Zynga's top rivals access to capital and the rights to popular game franchises. "If there is another Playfish that comes up, we'd like to be in the running," Pincus says. Still, the company won't rush into a deal. "The wisdom in business is that 50% of mergers don't work," says Bing Gordon, a former Electronic Arts executive, who, as a Zynga director, holds sway over how the company spends money. Advertiser ControversyThere's plenty to go around, thanks to the DST deal and the millions of dollars from virtual good sales. In April, Pincus said Zynga generated more than $100 million in annual revenue. Some analysts say the figure may rise to more than $300 million this year. Pincus won't discuss specifics for 2009 sales, though he concedes the company's revenue took a hit last month after Zynga dropped some controversial promotions. Certain in-game marketing ploys offered users virtual currency in exchange for signing up for misleading offers from third-party advertisers. As TechCrunch founder Michael Arrington pointed out in a blog in October, some offers resulted in users getting billed for monthly subscriptions they did not request. After removing most of the ads from Offerpal—the broker of such promotions—Zynga says its revenue dropped 10%. Still, the lack of promotions led to an uptick in users paying for more virtual goods that has almost canceled out the decline, Pincus says. DST wasn't deterred by the bad publicity. The investor sees Zynga, like Facebook, as a long-term prospect for growth, both in the U.S. and other countries. The model is similar to that of Tencent, an online game company in China, says Yuri Milner, CEO of DST. "Zynga is really executing the model that works elsewhere, like in China," he says. "That's exactly the reason why we think it's a big opportunity." The firm says it will not take a seat on Zynga's board or have much direct involvement in the company's operations. Neither DST nor Zynga would say where the investment pegs Zynga's total valuation. Analysts say the company may already be worth more than $1 billion. By welcoming new funds, Zynga is taking a detour from a public offering—a direction it had explored in recent months. Sensing the pressure Wall Street would put on its management, Zynga instead opted for the cash and liquidity offered by DST. The company will spend a portion of the investment round buying back stock from employees and other shareholders. Comments Gordon: "It's probably a pressure release."

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